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Delanceyplace: Chief Executive Officers

Nobel winning Princeton psychologist Daniel Kahneman writes about the impact of chief executive officers on the performance of their companies, and the effectiveness of business books based on an analysis of that impact.

CEOs do influence performance, but the effects are much smaller than a reading
of the business press suggests. Researchers measure the strength of relationships
by a correlation coefficient, which varies between 0 and 1. The coefficient was
defined earlier (in relation to regression to the mean) by the extent to which
two measures are determined by shared factors. A very generous estimate of the correlation
between the success of the firm and the quality of its CEO might be as high as .30,
indicating 30% overlap. ... A correlation of .30 implies that you would find the
stronger CEO leading the stronger firm in about 60% of the pairs -- an improvement
of a mere 10 percentage points over random guessing, hardly grist for the hero worship
of CEOs we so often witness. ...

In his penetrating book The Halo Effect, Philip Rosenzweig, a business school professor
based in Switzerland, shows how the demand for illusory certainty is met in two
popular genres of business writing: histories of the rise (usually) and fall (occasionally)
of particular individuals and com¬panies, and analyses of differences between successful
and less successful firms. He concludes that stories of success and failure consistently
exag¬gerate the impact of leadership style and management practices on firm outcomes,
and thus their message is rarely useful.

To appreciate what is going on, imagine that business experts, such as other CEOs,
are asked to comment on the reputation of the chief executive of a company. They
are keenly aware of whether the company has recently been thriving or failing.

As we saw earlier in the case of Google, this knowledge generates a halo. The CEO
of a successful company is likely to be called flexible, methodical, and decisive.

Imagine that a year has passed and things have gone sour. The same executive is
now described as confused, rigid, and authoritarian. Both descriptions sound right
at the time: it seems almost absurd to call a successful leader rigid and confused,
or a struggling leader flexible and methodical.

Indeed, the halo effect is so powerful that you probably find yourself resisting
the idea that the same person and the same behaviors appear methodical when things
are going well and rigid when things are going poorly. Because of the halo effect,
we get the causal relationship backward: we are prone to believe that the firm fails
because its CEO is rigid, when the truth is that the CEO appears to be rigid because
the firm is failing. This is how illusions of understanding are born.

The halo effect and outcome bias combine to explain the extraordinary appeal of
books that seek to draw operational morals from systematic ex¬amination of successful
businesses. One of the best-known examples of this genre is Jim Collins and Jerry
I. Porras's Built to Last. The book contains a thorough analysis of eighteen pairs
of competing companies, in which one was more successful than the other. The data
for these comparisons are ratings of various aspects of corporate culture, strategy,
and management practices. 'We believe every CEO, manager, and entrepreneur in the
world should read this book,' the authors proclaim. 'You can build a visionary company.'

The basic message of Built to Last and other similar books is that good managerial
practices can be identified and that good practices will be re-warded by good results.
Both messages are overstated. The comparison of firms that have been more or less
successful is to a significant extent a com¬parison between firms that have been
more or less lucky. Knowing the importance of luck, you should be particularly
suspicious when highly consistent patterns emerge from the comparison of successful
and less successful firms. In the presence of randomness, regular patterns can only
be mirages.

Because luck plays a large role, the quality of leadership and management practices
cannot be inferred reliably from observations of success. And even if you had perfect
foreknowledge that a CEO has brilliant vision and extraordinary competence, you
still would be unable to predict how the company will perform with much better accuracy
than the flip of a coin. On average, the gap in corporate profitability and stock
returns between the outstanding firms and the less successful firms studied in Built
to Last shrank to almost nothing in the period following the study. The average
profitability of the companies identified in the famous In Search of Excellence
dropped sharply as well within a short time. A study of Fortune's 'Most Admired
Companies' finds that over a twenty-year period, the firms with the worst ratings
went on to earn much higher stock returns than the most admired firms.

You are probably tempted to think of causal explanations for these observations:
perhaps the successful firms became complacent, the less successful firms tried
harder. But this is the wrong way to think about what happened. The average gap
must shrink, because the original gap was due in good part to luck, which contributed
both to the success of the top firms and to the lagging performance of the rest.
We have already encountered this statistical fact of life: regression to the mean.

Stories of how businesses rise and fall strike a chord with readers by offering
what the human mind needs: a simple message of triumph and failure that identifies
clear causes and ignores the determinative power of luck and the inevitability of
regression. These stories induce and maintain an illusion of understanding, imparting
lessons of little enduring value to readers who are all too eager to believe them.

Author: Daniel Kahneman
Title: Thinking Fast and Slow
Publisher: Farrar, Straus, and Giroux
Date: Copyright 2011 by Daniel Kahneman
Pages: 205-208

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